Demand and prices fall

Sam FletcherSenior Writer

Even as a winter storm dumped snow and ice on the US Midwest and East Coast during Christmas week, markets remained unconvinced the Organization of Petroleum Exporting Countries can cut production fast enough to offset plummeting demand for oil.

"The colder weather continues to take a backseat to economic concerns, which are now weighing heavily on industrial and power generation demand," said analysts in the Houston office of Raymond James & Associates Inc. "Two of the world's biggest oil importers reported significant year-over-year declines in oil demand. Japan, the world's third biggest oil importer, reported its November crude imports were down 17% from the previous year, and South Korea, the world's fifth biggest importer, reported that its oil consumption was down 12% in November."

In New Orleans, Pritchard Capital Partners LLC analysts reported Abu Dhabi verbally informed India's Bharat Petroleum Corp. Ltd. to expect a cut in oil supplies in January, while Saudi Arabia and Kuwait had not yet issued similar notices. Meanwhile, crude production by Petroleos Mexicanos fell 6.5% from year-ago levels in November. Pemex reduced its 2008 production outlook for the third time, down 3.6% due to disruptions by hurricanes and the faster-than-expected decline of Cantarell field.

Demand outlookOn the natural gas front, Pritchard Capital analysts said, "The gas market seems poised to reset itself," in a process that includes shutting in some production and a more than a 30% drop in the number of active land rigs in the US. They see "a 4-6 month lag time before recent well decline rates translate into production volume decreases. We may see gas prices around $5/Mcf before things get better."

Pritchard Capital also perceives a shift from a supply-constrained market to a demand-constrained market for LNG. "Global LNG prices on the spot market seem to be stabilizing [at] $8-9/MMbtu in the Atlantic Basin and in the $11-12 range in the Pacific Basin." With prices at the Henry Hub, La., spot market "well below the prices a year ago," LNG terminals at Lake Charles, La., and at Sabine Pass and Freeport in Texas remain inactive, analysts said.

Olivier Jakob at Petromatrix, Zug, Switzerland, observed, "With the low oil prices and the low refining margins, the process of supply destruction is already in the works, and this is further evidenced by the falling trend of rotary rig utilization. Most of Wall Street is now targeting $30/bbl for West Texas Intermediate, a level which will only accelerate the supply destruction process in North America, making the US more dependent on 'foreign oil.'" More important, low oil prices "will be destroying production capacity, which will then allow for a reversal trade," Jakob said.

He added, "The [futures market] price of corn or soybean is holding much better than gasoline or heating oil, the ethanol processing margins are in the red, and the current oil prices also question the sustainability of biofuels in the supply and demand equation. The retail price of gasoline in the US is at the lowest level since early 2004 and with the gasoline crack giving back some of its recent gains, there should be some more improvement in the pump price for the US customer."

Paul Horsnell, Barclays Capital Inc., London, said, "Although the pace of decline in commodity prices has slowed in December, we believe there is still downside risk to prices should financial markets remain unstable, the dollar continue to strengthen and global growth projections continue to suffer cuts. Significant portions of existing output are unable to cover cash costs at current prices and output cuts are being rapidly enacted alongside the deferral of large numbers of new projects that have become very difficult to finance in the current environment. The damage being done to the supply side suggests prices could recover rapidly once the mood of pessimism surrounding global growth prospects starts to clear. We expect price volatility to stay elevated by historical standards as liquidity is thin, short positions in a number of markets are large and the potential for both demand and supply shocks is high."

Horsnell said, "We are in the midst of the most severe global recession since at least the early 1980s, if not the Great Depression. It is difficult to find an economy anywhere in the world that is not being hit hard, and the downward momentum underway virtually ensures that activity will continue to fall significantly through first quarter. The baseline Barclays Capital forecast expects the economic contraction to find a bottom around mid-year, but the recovery to be well below par."